Many U.S. taxpayers have at least one financial account located in a foreign country. Failure to report an offshore account carries with it possible civil and criminal penalties. Foreign account reporting requirements are provided for under the Bank Secrecy Act, enacted in 1970. The legislation was intended to assist U.S. investigators in preventing offshore tax evasion and in tracing funds used for illicit purposes. Actual reporting of foreign accounts and the filing of Foreign Bank and Financial Account Reports (FBARs) has been required since 1972, but the rule had been largely ignored by taxpayers., prompting Congress to amend the requirements.

Amended FBAR regulations became effective in 2011. 31 C.F.R. § 1010.350 now provides that each “United States person” having a financial interest in, or “signature authority” over, a bank, securities, or other financial account in a foreign country must file an FBAR. A United States person includes U.S. citizens and residents, and domestic corporations, partnerships, estates, and trusts. Having signature authority over a foreign financial account means that the person can control the disposition of money in the account by sending a signed document to, or orally communicating with, the institution maintaining the account. The FBAR has proven to be an effective tax compliance tool for the IRS, since penalties may be imposed upon taxpayers maintaining foreign accounts which earned no income. This unfairness led to the inauguration of a “streamlined” disclosure program, discussed below.

31 C.F.R. § 1010.306(c) provides that an FBAR must be filed if the aggregate value of all foreign financial accounts is more than $10,000 at any time during the calendar year. Therefore, a U.S. person who owns several small financial accounts in various countries, whose total value exceeds $10,000 at any time during the calendar year, would be required to file an FBAR. Some exceptions to the FBAR filing requirement exist. For example, no FBAR is required to be filed by the beneficiary of a foreign trust. The FBAR must be filed by June 30. (Form TD F90-22.1). The existence of foreign financial accounts is reported by checking the appropriate box on Schedule B of Form 1040. 31 C.F.R. § 1010.306(c). Extensions given by the IRS for income tax returns will not operate to extend the FBAR filing deadline of June 30.

The civil penalty for failure to file the FBAR is $10,000 for each non-willful violation. Where a taxpayer willfully fails to file, civil penalties are the greater of $100,000 or fifty percent of the highest balance of the unreported account per year, for up to six years. Criminal penalties for willful violations run as high as $500,000, with the possible sanction of imprisonment for up to ten years. Those taxpayers required to file FBARs may also be required to file Form 8938 (Statement of Specified Foreign Financial Assets) if the amount of assets exceeds a certain threshold.

Form 8938 is required if the taxpayer has foreign financial accounts (or other specified foreign financial assets) exceeding $50,000 ($100,000, if married filing jointly) on the last day of the tax year or $75,000 ($150,000, if married filing jointly) at any time during the tax year. For the purpose of Form 8938, specified foreign financial assets include partnership interests in foreign partnerships, notes or bonds issued by a foreign person, and interests in foreign retirement plans. Note that taxpayers are not required to report ownership of foreign real property on Form 8938, as Form 8938, as well as the FBAR, operate exclusively to apprise the Service of the existence of foreign financial accounts. Failure to file Form 8938 may result in a penalty of $10,000, even if the foreign assets were actually reported on the FBAR.

Other information returns that may be required for persons owning foreign assets include (i) Form 3520 (Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts); (ii) Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner; (iii) Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations); (iv) Form 5472 (Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business); (v) Form 926 (Return by a U.S. Transferor of Property to a Foreign Corporation); and (vi) Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund).

Remedies for Taxpayers Who Have Failed to Report Foreign Assets, Foreign Accounts, or Foreign Source Income

Taxpayers who have failed to report foreign source income or foreign assets may be eligible to participate in a disclosure program. Acceptance into the OVDP program is conditioned upon IRS approval following partial disclosure. Those participating in a disclosure program enjoy the elimination of exposure to criminal sanctions, and may incur fewer tax penalties. Participation in these programs can only occur if the taxpayer has not been subject to audit. The existence of an audit will result in all bets being off for the taxpayer. One downside to electing to apply for the OVDP programs is that if the taxpayer is ultimately not accepted into the program, he may have provided the IRS with a blueprint for audit. Taxpayers not participating in any program may instead choose to make a “soft disclosure” by filing all required returns with the hope that no tax audit occurs within the applicable period of limitations. Currently, the following four disclosure programs exist:

(iv) the Delinquent International Information Return Submission Procedures (the

“International Return Procedures”).

The Offshore Voluntary Disclosure Programs

To penalize more sharply taxpayers who have willfully failed to report foreign financial assets and to ease the burden on taxpayers who have non-willfully failed to comply with foreign reporting requirements, the IRS modified the Offshore Voluntary Disclosure Program (OVDP) on July 1, 2014. Subsequent to the modifications, the OVDP has generally remained the best available disclosure option for taxpayers who have acted willfully. Taxpayers falling into the non-willful category may seek to participate in the Streamlined Procedures.

The OVDP

The OVDP permits taxpayers who have willfully failed to disclose foreign accounts to correct past non-compliance. Taxpayers accepted in the OVDP program will avoid criminal prosecution and benefit from fixed, ascertainable penalties. A taxpayer may be accepted into the OVDP program if no audit or investigation has been commenced, or if the IRS has not received information from a third party concerning non-compliance. Understandably, taxpayers maintaining offshore accounts housing illegal sources of funds may not qualify for relief under the program.

To participate in the current OVDP, taxpayers must first make a partial disclosure. The modified OVDP now requires the disclosure of more information at this pre-clearance stage. In addition to taxpayer identifying information, information concerning financial institutions, foreign entities, and domestic entities at issue must also be provided. The IRS will notify taxpayers within thirty days concerning whether conditional acceptance has been approved. Taxpayers that obtain pre-clearance to enter the OVDP must make the next required submission within 45 days. That submission consists of a narrative identifying the accounts, the location of the accounts, and the source of the income of the offshore accounts. IRS Criminal Investigations will review the submission and issue notification within 45 days. Taxpayers passing the second submission stage are allowed 90 days in which to make a final disclosure submission, which includes copies of previously filed original tax returns, as well as amended tax returns, for the prior eight tax years. Payment of tax on unreported income, as well as an accuracy-related penalty of twenty percent, and interest, must be paid as part of the final disclosure submission.

Following the IRS review and approval of the final disclosure submission, the taxpayers will be furnished with a closing agreement, setting forth the penalty structure. Taxpayers may make an irrevocable election to forego the closing agreement and instead submit to a standard audit. Taxpayers opting to not execute the closing agreement will not forego protection against criminal prosecution provided the taxpayer continues to cooperate. The “miscellaneous penalty” imposed on taxpayers accepted into the OVDP is equal to a percentage of the highest aggregate value of foreign accounts. That percentage is 27.5, rising to fifty percent if the foreign financial institution holding the account is under investigation by the IRS or the Department of Justice. The IRS publishes an updated list of these “blacklisted” institutions on its website. The number of such institutions has increased steadily, and consisted of ninety-five institutions as of February 5, 2016.

The Streamlined Procedures

Recent modifications to the OVDP created for the first time a separate filing procedure for taxpayers who non-willfully failed to comply with reporting requirements. Unlike the OVDP, the “Streamlined Procedures” provide no assurance that criminal prosecution will be avoided. The Streamlined Procedures are, as its name implies, simpler than the procedures involved in participating in the OVDP. Multiple submissions are not required. Instead, participating taxpayers submit all required documentation in one phase. The Streamlined Procedures also require the submission of fewer tax returns. While the OVDP requires the submission of eight years of amended income tax returns and information returns (e.g., FBARs and Form 8938) , the Streamlined Procedures require only three years of amended income tax returns (and the payments of associated taxes, interest, and penalties), six years of FBARs and three years of any other information returns (e.g., Form 8938). The Streamlined Procedures impose significantly lesser penalties than the OVDP. Eligible taxpayers residing in the United States, in addition to paying tax (and applicable penalties, if any) on unreported income, must pay a miscellaneous offshore penalty equal to five percent (rather than 27.5 or fifty percent, as the case may be) of the highest aggregate year-end value of the unreported foreign financial assets. Non-resident taxpayers are exempt from the miscellaneous offshore penalty.

Only individual taxpayers (including estates of deceased taxpayers) may participate in the Streamlined Procedures. An important part of the submission consists of the Certification: Participating taxpayers must certify that their failure to report all income, pay all tax, and submit all required information returns was due to non-willful conduct. As with the OVDP, participation is excluded if the IRS has initiated a civil examination of taxpayer’s returns for any taxable year or has commenced a criminal investigation. So too, electing to participate in the Streamlined Procedures precludes participation in the OVDP and vice versa. Although the Streamlined Procedures impose lower penalties than the OVDP, there is less assurance that the taxpayer will be accepted, since he must demonstrate that the failure was non-willful. Again, failing to be accepted into the program will result in the IRS possessing a significant amount of information which it may then use in an audit, be it civil or criminal.

The element of non-willfulness in failing to properly report and pay tax must be shown by means of a detailed narrative. The IRS will reject submissions which it finds lack sufficient detail. As noted, there is also a risk that the IRS will determine that individual taxpayers in fact acted willfully, thus opening up a potential Pandora’s box. According to the IRS (but not necessarily the Courts), “non-willful” conduct is conduct due to negligence, inadvertence, or mistake or conduct that is the result of a good faith misunderstanding of the requirements of the law. In determining whether a taxpayer has acted non-willfully, the IRS states that it will consider the facts and circumstances. However, the IRS has provided little guidance as to specific circumstances that will be considered. Further, there is a dearth of case law providing clarity on this issue.

The Fourth Circuit recently determined that a taxpayer acted willfully by failing to disclose the existence of a foreign account by falsely checking the box “no” on Schedule B (which elicits a response concerning the existence of a foreign account.) United States v. Williams, 489 F. App’x 665 (4th Cir. 2012), reasoned that the question instructed taxpayers to refer to the FBAR instructions, putting the taxpayer on notice with respect to FBAR requirements. The Court remarked that willfulness can be inferred from a conscious effort to avoid learning about reporting requirements . . . and may be inferred where a defendant was subjectively aware of a high probability of the existence of a tax liability, and purposely avoided learning the facts. The Court dismissed as irrelevant the claim that the taxpayer had not in fact reviewed the return.

In determining willfulness, the IRS may also consider the source of funds held in foreign account. The Service is more likely to find a taxpayer acted willfully if the foreign financial account either produced unreported income or if the source of funds of the foreign financial account derived from unreported foreign source income. The IRS may also consider the financial sophistication and education of the taxpayer, any history of tax compliance (or lack thereof) by the taxpayer, and also whether the taxpayer disclosed the existence of foreign accounts to the return preparer or tax preparer.

The Delinquent FBAR Submission Procedures (“Delinquent FBAR Procedures”) supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms provided for automatic exemption from penalties where the taxpayer had no unreported income and whose only failure consisted of not filing FBARs (or filing inaccurate FBARs). The FBAR Submission Procedures made no changes to OVDP provisions which it superseded. To qualify for the Delinquent FBAR Procedures, the taxpayer must not be under a civil examination or criminal investigation and must not have been taxpayers must have been contacted by the IRS concerning an audit or delinquent information returns.

Delinquent International Information Return Submission Procedures

The Delinquent International Information Return Submission Procedures (“International Return Procedures”) also supersede provisions of the OVDP existing prior to the OVDP modifications. Those terms also provided for an automatic exemption from penalties where the taxpayer had no unreported income and whose only failure related to the non-filing of international information returns other than FBARs (or the failure to file accurate international information returns that were not FBARs). Applicable international information returns include, but are not limited to, Form 8938, Form 3520, and Form 5471.

As is the case with the Delinquent FBAR Procedures, taxpayers must not be under either a civil examination or criminal investigation, or have been contacted by the IRS concerning an audit or delinquent information returns. However, Unlike the Delinquent FBAR Procedures described immediately above, the International Return Procedures apply to taxpayers irrespective of whether there was or was not unreported income. In addition, penalties may now be imposed if the taxpayer cannot demonstrate reasonable cause for the failure to file the required information returns.

The IRS has elaborated that longstanding authorities regarding what constitutes reasonable cause continue to apply, citing as examples Treas. Reg. §§ 301.6679-1(a)(3) and 1.6038A-4(b), and 301.6679-1(a)(3). § 301.6679-1(a)(3) provides that a taxpayer that exercises ordinary business care and prudence has reasonable cause. § 1.6038A-4(b) provides that the determination of whether a taxpayer acted with reasonable cause is made considering all the facts and circumstances. Circumstances that would qualify as reasonable cause include honest misunderstanding of fact or law, as well as reasonable reliance on the advice of a professional.

Treas. Reg. §301-6724-1 provides a list of factors that may demonstrate reasonable cause. For example, reasonable cause is more likely to be found to exist where the taxpayer has an established history of compliance (Treas. Reg. §301-6724-1(b)(2), where the compliance failure concerned a requirement that was new for a particular taxpayer (Treas. Reg. §301-6724-1(b)(1)), or where the compliance failure was due to events beyond the control of the taxpayer (Treas. Reg. §301-6724-1 (c)).